Is a Tax Write-Off Actually Free Money?

The idea that a tax write-off is a form of “free money” is a common misunderstanding. While the term suggests an expense simply vanishes from one’s financial obligations, a write-off operates within the structured rules of the tax system to lower the amount of income on which you pay tax.

Understanding Tax Write-Offs

A “tax write-off” is the conversational term for what the Internal Revenue Service (IRS) calls a tax deduction. A deduction is an expense you can subtract from your total income to determine your taxable income. This means the government only taxes this adjusted amount, not your entire earnings.

The purpose of a deduction is to acknowledge that it costs money to earn money, particularly for businesses or self-employed individuals. For an expense to be a legitimate write-off, the IRS requires it to be both “ordinary and necessary” for conducting your business. An ordinary expense is common in your industry, while a necessary expense is helpful for your business.

A deduction does not directly reduce the amount of tax you owe. Instead, it shrinks the pool of money that the government taxes. For example, if you earn $60,000 and have $5,000 in deductions, your taxable income becomes $55,000.

The Financial Impact of a Write-Off

The savings from a deduction are tied to your marginal tax rate, which is the rate you pay on your highest dollar of income. For example, consider a self-employed graphic designer in the 22% federal income tax bracket. This rate was established by the Tax Cuts and Jobs Act of 2017 and is scheduled to expire after 2025, unless extended by Congress.

The designer purchases a new graphics tablet for their business, costing $1,000. They can claim this as a tax deduction, which reduces their taxable income by the full $1,000. If their taxable income was $50,000 before the purchase, it is now $49,000.

The actual tax saving is the deducted amount multiplied by their tax rate. In this case, the savings would be $1,000 multiplied by 22%, which equals $220. This means the designer will pay $220 less in federal income taxes. The write-off did not make the tablet free; it simply provided a discount.

The final out-of-pocket cost for the designer is the initial price of the item minus the tax savings. The tablet cost $1,000, and the tax deduction saved them $220, making the net cost to the designer $780. This demonstrates that a write-off is a cost reduction, not a grant of free money.

Distinguishing Deductions and Credits

A tax write-off’s value is clearer when compared to a tax credit. While a deduction reduces your taxable income, a tax credit directly reduces your final tax bill on a dollar-for-dollar basis, making it more powerful. The IRS offers credits for activities like pursuing education or making certain energy-efficient home improvements.

Using the previous example, a $1,000 deduction in the 22% tax bracket saved the taxpayer $220. A hypothetical $1,000 tax credit, however, would reduce their tax liability by the full $1,000. If the designer owed $5,000 in taxes, the credit would lower their bill to $4,000.

A deduction’s value is dependent on the taxpayer’s marginal tax rate, while a credit’s value is fixed. Some credits are “refundable,” meaning if the credit is larger than your tax liability, the government sends you the difference. Nonrefundable credits can only reduce your tax liability to zero.

Examples of Common Write-Offs

For self-employed individuals and small businesses, common deductions include:

• The cost of business mileage
• Office supplies
• Rent for a commercial space
• The home office deduction
• Business-related travel
• Professional fees for services like accounting or legal advice
• Business insurance premiums
• One-half of self-employment taxes
• Contributions to certain retirement plans, such as a SEP IRA or solo 401(k)

Individuals who are not self-employed can take the standard deduction, which is a fixed amount based on filing status. If a taxpayer’s specific deductible expenses exceed the standard amount, they can itemize them on Schedule A of Form 1040 instead.

Common itemized deductions include:

• Mortgage interest
• State and local taxes up to a $10,000 limit
• Charitable contributions
• Medical and dental expenses that exceed 7.5% of adjusted gross income

Several provisions for individuals are temporary. The higher standard deduction amounts and the $10,000 cap on state and local tax deductions are set to expire after 2025. Unless Congress passes new legislation, the standard deduction will revert to a lower amount, and the limit on the state and local tax deduction will be removed, which will affect how many taxpayers choose between the standard deduction and itemizing.